Research

There is a sea-change occurring in the way investors are
considering potential hedge fund investments. No longer are
investors satisfying themselves with a rudimentary review
of a fund prior to an investment. Now best practice dictates
that detailed due diligence must occur prior to, and on-going
monitoring must occur following, any investment. It is now
recognised that the level of due diligence applied to hedge
funds should be of a standard similar to that usually applied
to private M&A transactions, particularly those undertaken
by private equity firms. The reason why this 'sea-change'
has occurred is down to a combination of macro as well as
or hedge fund-specific factors.

In our view the investment process can be divided into four
overlapping stages, they are: 1. screening potential hedge
funds for investment; 2. identifying (by performance reviews
and management presentations) potential investment targets;
3. conducting a full due diligence review on those targets;
and 4. continually monitoring the fund once the investment
has been made. This article discusses the latter two phases
of the investment process, that is the due diligence review
of a targeted fund as well as the need to be proactive in
monitoring an investment once made.

The reasons for heightened diligence

Micro factors ~ reasons specific to the hedge-fund community

The hedge fund investment community has (hopefully) learnt
some valuable lessons recently from high-profile hedge fund
frauds and failures. There are a great many hedge funds now
managed by a great many principals. The community is no longer
a small one; instead it is hugely diverse in terms of number,
geographical location and investment strategies. Now, when
a hedge fund first gains the attention of an investor it is
most likely that the officers and corporate structure of the
fund are almost completely unknown. Accordingly there is a
lot to know (or that should be known) about a fund and its
manager before an investment is made.

Secondly, and as a direct result of the exponential growth
in hedge funds, there are now so many funds in existence that
not every manager has the necessary experience or expertise
to successfully deliver returns. The recent increase in the
number of liquidations in Europe and the United States of
hedge funds provides anecdotal support for this conclusion.
Accordingly the rapid growth in the number of hedge funds
arguably means that there is now a greater proportion of inexperienced
managers in the field and thus there is a greater risk of
a failed investment.

Finally as a result of the rapid growth of, and competition
between, funds of hedge funds, these portfolios cannot afford
to get investments wrong. The reputational damage is particularly
acute when the flawed investment could have been avoided with
the application of basic due diligence procedures.

Macro factors ~ global trends

It is easily acknowledged that the international corporate
governance culture has radically shifted (for the better)
in the last 12 months. Directors and senior management, in
all industries, are now obliged to take more precautions and
apply more stringent diligence processes to enhance (and protect)
shareholder value. This is also the case for the directors
and officers of funds of hedge funds, and other fiduciary
investors, who are adding alternative investments to their
portfolios, as they have corporate and fiduciary responsibilities
to have absolute regard for the interests of their underlying
holders.

There has also very recently been a renewed emphasis internationally
on the implementation and expansion of anti-money laundering
procedures. New rules, particularly those emanating from the
United States, will soon require many hedge fund investors
to diligence potential hedge fund investments to ensure that
the target: (i) is not a front for the laundering of illegal
gains; and (ii) has appropriate procedures in place to ensure
that it is not unwittingly being used for the purpose of laundering
illegal gains (see further "USA PATRIOT Act Rules
to Hit Offshore Hedge Funds"). This will mean that
a due diligence exercise must now take even more account of
the target's potential vulnerabilities to money laundering.

Due diligence is now more than ever recognised as an important
risk-management exercise. As with any transaction the risk
profile of the targeted investment must be fully assessed
and addressed (to whatever extent it can be) before the investment
is made. Arguably the risk profile cannot be fully and completely
assessed unless and until due diligence has taken place. Usefully,
thorough and effective due diligence can address a number
of factors on a risk profile (i.e. a systems' risk can be
addressed by a review of the adequacy of the fund's systems,
financial reporting procedures, risk management controls,
etc). Naturally the risk profile of an investment increases
in proportion to the size of the investment. Accordingly the
greater the investment the greater the need to apply more
risk-management processes, accordingly the need for more detailed
and thorough due diligence results.

What is the aim of hedge fund due diligence?

The aim of hedge fund due diligence is simple - it is to:
1. properly determine the risk profile of an investment
by discovering in great detail as much as one can about a
hedge fund, its performance, management and structure; and
2. address as many of those risks as possible. Unfortunately
many due diligence exercises appear to be undertaken without
these aims in mind so that the risk profile of a transaction
is never properly determined (or indeed addressed) nor are
an investor's future expectations as to the investment properly
established. Of course it has to be recognised that due diligence
is an evolving process that can both satisfy perceived risks
and raise potential risks not originally foreseen.

Since the optimum investment horizon for a hedge fund stake
is a medium- to long-term one, investors should not take comfort
from the fact that they are able to withdraw their investment
at the next redemption date (usually the following month or
quarter; though more and more funds now have initial lock-ups
or redemption penalties for up to 12 months) as there is a
great opportunity cost in the form of the wasted time value
of the failed investment. Investors also run the risk, because
of these restrictions on redemptions, of not being able to
withdraw from the fund until it is too late. Furthermore,
investors should avoid obtaining the reputation of having
'hot money' (when a redemption quickly follows the investment)
as the hedge fund community will not regard them as a quality
investor and may shy away from them in the future. Accordingly
the aim of due diligence is to maximise the potential for
running the investment into the preferred medium- to longer-term
horizon by minimising the risk of having to withdraw the investment
in the short-term (or having the investment fail completely).

Relevant due diligence to hedge funds

When investing in hedge funds it is vital to properly ascertain
the risk profile of a hedge fund by gathering as much information
as is possible about the fund and its manager but always in
the context of recognising what you are actually buying. Our
view is that you are primarily buying into four factors when
investing in a hedge fund: the first is the expertise and
capabilities of the principal officers within the investment
management firm; the second is the strategies, processes and
systems of that manager; the third is the fund's performance;
and finally an investor is buying into the fund's corporate,
tax, regulatory and custodial structure.

In addressing these principal factors investors must be prepared
to invest a great deal of time and effort into the due diligence
process. Given that the availability of hedge fund liquidity
is usually limited to subscription every quarter or month,
the opportunity cost of the investment of time is lessened
and investors should use this opportunity to embark on a detailed
review.

Diligencing performance

Performance, or performance potential, is fundamental to
any investment. This must be diligenced thoroughly and every
available piece of data must be collected in relation to all
funds currently and historically managed by the manager and
its principal officers. Diligencing performance crosses over
with the earlier stages of the investment process, namely
the targeting of funds (a topic outside this discussion).
Nevertheless, diligencing performance does not stop with the
targeting process and aside from reviewing historical NAVs
investors should look to investor churn (i.e. the frequency
of redemptions) to assess investor satisfaction (again this
should be analysed for each fund either currently or historically
managed by the manager and its key investment officers). Another
important exercise is actually auditing (i.e. verifying) the
fund's historical performance figures to ensure their accuracy
as well as the proper accounting of all the historical fees
and expenses.

Diligencing the principal officers of the manager

Perhaps more than in any other investment case the expertise,
capabilities and experience of a hedge fund manager is crucial
to the success of the fund. Hedge funds live and die principally
because of an individual's investment philosophy and their
particular application of a fund's investment strategy. The
due diligence standard we believe is applicable is the same
standard of care that a private equity firm would undertake
in diligencing the management of a target company. Accordingly
it is essential to know as much as possible about the principals
of the management company, their investment philosophy, their
historical performance and their background. Moreover, it
is important to determine the possibility of the key individuals
leaving the investment management team during the term of
the investment.

Of course there is no single due diligence approach that
can be applied in all cases, but it is not just a case of
receiving management presentations on the fund, nor is it
just a matter of cursory discussions with the relevant individuals.
Instead, due diligence on key individuals is an all-encompassing
and evolving process and great importance should be attached
to acquiring as much detail as possible about any given individual
via individual background checks. There should also be emphasis
on spending a great deal of time meeting with, and interviewing,
the key principals of the fund and making enquiries around
the industry with people who have previously dealt with the
individuals involved.

Diligencing a hedge fund's strategies, processes and systems

This portion of the due diligence process will occupy a great
deal of the investor's time as there are many facets to this
review exercise, including diligencing the:

Investment strategy (including understanding the manager's
philosophy or the biases behind that strategy);

Risk management programmes (including the leverage, hedging,
diversification and external control programmes applied) and
determining whether the manager comprehensively understands
the risks associated with its strategy (including any counterparty
risk and the V.A.R - the value at risk);

The fund's systems and trading procedures, with particular
emphasis on how cash is managed (and supervised) from investment
right through to redemption;

The frequency & manner of investor reports; and

Compliance and anti-money laundering programmes (including
compliance with the proposed new US anti-money-laundering
rules for offshore hedge funds).

Since international best-practice processes and systems are
available to all hedge funds, it is our view that unless a
fund's processes meet these international standards an investment
cannot be justified.

Diligencing a hedge fund's structure

Many hedge funds exist with offshore incorporation and with
little or no regulatory transparency (although this is changing
as a result of the USA PATRIOT Act - see "USA PATRIOT
Act Rules to Hit Offshore Hedge Funds"). Despite
the fact that the slight regulatory veil covering offshore
hedge funds is often perceived as a positive factor, there
are greater risks associated with entities that exist in a
non-transparent regulatory regime particularly because the
basic standards (usually dictated by proactive regulators)
do not necessarily apply to many of these funds. Accordingly
in order to address these risks proper independent regulatory
and legal checks should be carried out to ensure the due incorporation
and proper licensing of both a hedge fund and its manager.

A particular jurisdictional issue at present that should
form part of the investment review is the uncertainty relating
to the tax treatment of funds managed by entities based in
Hong Kong and Japan. Since many of these funds execute their
trades in these jurisdictions there is a view that a taxation
nexus exists and that the offshore funds themselves would
be liable to Hong Kong or Japanese tax. Unfortunately the
position has not been clarified by the relevant taxation authorities
and this issue remains an important component of diligencing
funds managed out of Tokyo or Hong Kong.

Also necessary is an analysis of the investment characteristics
of the fund to ascertain whether those details correspond
with an investor's own investment objectives and guidelines.
This analysis would include a review of the following factors:

A fund's size & its maximum size

The level of management & performance fees as well as
hurdle rates & manner of calculation

A fundamental issue in reviewing the structure of the fund
is to ensure that proper third-party custody of the fund's
assets is provided for and the external calculation of its
net asset value exists. This 'separation of powers' doctrine
is now regarded as the absolute norm as it minimises the risk
of 'creative' valuation or the misuse of the assets of the
funds.

Moreover, different structures have different tax implications
for the end investor, and this is particularly the case for
US persons. Accordingly, an investor must assess the tax effectiveness
of an investment in order to avoid losing the benefit and
attraction that the offshore fund may offer.

Good hedge fund due diligence practice

In summary hedge fund due diligence should be an exhaustive
process. Best due diligence practice recognises that an investor's
own team cannot, by itself, cover all of the bases necessary
for a thorough due diligence review. Instead, the expertise
of professional advisors - such as background researchers,
lawyers, accountants and systems experts - are often needed.
Moreover, investors must be ready to engage these trusted
professionals when they embark on an investment outside their
known sphere of knowledge, particularly with regard to strategy
or geography. The reality is that hedge fund investors cannot
be expected to know everything about every strategy and every
manager in every location. Accordingly a due diligence team
should be assembled containing the appropriate third-party
professional advisers.

Once the team is assembled a due diligence questionnaire
should be tailored to the specific structure, strategy and
perceived risks of the investment. Due diligence should be
treated as an evolving, and not a static, process in order
to assess whether the perceived risks are real and whether
other risks exist. Only once the due diligence review has
been substantially undertaken can an investor properly assess
the worthiness of the potential investment. It is at this
due diligence stage that the investor's investment team should
be prepared, and willing, to forgo an investment (despite
the positive results of the identifying and targeting phases
of the process) as due diligence can often turn up unforeseen
risks.

Following the investment: after-the-fact diligence

The final factor to recognise is that hedge fund due diligence
should not stop with the investment. Instead it is vital that
hedge fund investors continue to actively monitor the performance
and activities of each of their investments to ensure that
the expectations formed during initial due diligence are met.
Unfortunately it is the case that some investors have been
burnt by having a bias towards almost complete reliance on
a manager's disclosure. We would suggest that best practice
is for the investor to be pro-active in monitoring and questioning
each manager. It is vital to ensure that the manager is firstly
doing what he says he would do (i.e. no style shift); and
secondly is not exposing the fund to any illiquid investments,
which is a particular trap in Asia. Better practice suggests
that after-the-fact due diligence should take the form of
at least bi-annual meetings with the manager during which
weekly performance and monthly summaries (to include a list
of top holdings) should be thoroughly reviewed. Moreover,
investors should be prepared to conduct 'event-driven' due
diligence or monitoring in response to changes in market,
economic or political factors.

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